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FX: Being Long Euro Makes Sense (5 Reasons Why)
From diminishing fragmentation risks to cheap implied volatility, here's why we like buying EUR.
Data such as inflation and GDP supports ECB action
Falling tail risks such as natural gas prices and bloc break up aid to confidence
Current spot levels and volatility vs USD offer an attractive entry point now
There’s been some chatter over the past week or so that EUR underperformance is here to stay. Indeed, we’ve been surprised by the lack of EUR buying in the market recently, but don’t see it as something to be overly concerned about when looking at the longer-term fundamental backdrop. Here are several reasons to back up our view:
1.Natural Gas Prices
For all of the concern around the weaponizing of natural gas from Russia last year, conditions have completely reversed over the past couple of months.
The pricing of the EU Dutch TTF natural gas contracts below highlights this, with it trading at the lows of the past year.
When we couple this with the Eurozone coming out of a mild winter (just ask the skiers who ventured to France), and the concern built in to the currency should be able to be priced out as we hit spring.
It’s difficult to quantify this when trading EUR crosses, but we feel it’s more of a reason to have confidence in buying dips rather than fading rallies.
2.Core Inflation Levels
It was flagged up to us earlier in the week that core EU inflation is now the same as that of the US at 5.6%. This is noteworthy by itself, but compounds when you think about what the implications of this are.
One way we’re looking at it is via EUR/USD and the EU/US rate differentials. We feel that rates in the US are close to peaking, with circa 5.5% seeming the most likely landing ground. Yet for the EU, we don’t feel rates (currently with a terminal pricing of 4%) is close to where it should be.
We feel that with components of the core inflation reading being sticky, the ECB will need to push the rate closer to 4.5% in early 2024.
When you combine what this means for the rate differential, it makes a strong case for supporting EUR/USD to move higher.
Another negative brush stroke that the Eurozone has been painted with over the last year is fragmentation risk. However, we see the outlook here diminishing, based on a few principles.
Firstly, several major banks have flipped in their view about a Eurozone recession this year. This is shown by the below chart, with the far right highlighting from the European Commission a forecasted GDP growth rate of 0.8% for 2023.
Given the spread of growth around the nations, we don’t see any countries (bar Sweden) of massively underperforming and therefore causing friction for the whole bloc.
Another factor is the fortitude and resolve the bloc has given the war on its doorstep. Within the mantra of the nations we don’t feel there’s a strong desire to cause unnecessary problems while the war is ongoing. Granted, this is a risk should we get peace, but being divisive at a time when unity is called on wouldn’t sit well.
We’re seeing more and more headlines like the below in recent weeks:
What this shows us is that investors are cycling out of US stocks and finding more attractive valuations in European counterparts.
In a note that Goldman Sachs put out on the topic, they commented that: "While Europe has been outperforming since late 2022, it still trades at a discount compared with the U.S. in virtually every sector."
Naturally, this momentum should help to lift EUR in coming weeks/months as investors need to purchase local denominated equity.
5.How To Trade It
The final reason we like to buy EUR now is due to the attractive entry points for trading it.
One month EURUSD ATM Option volatility is currently at 8.10, close to the lowest levels over the past year. From this, we feel that buying upside options is a relatively cheap way to make a play. For example, a one month 1.0800 vanilla call on EURUSD only costs 0.4% due to the low implied volatility.
For a zero cost structure, add on selling a 1.0475 Put for the same timeframe.